Five Ways to Profit from the Real Estate Recovery

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

US housing has been improving for nearly a year now, so the trend is already quite clear at this stage. Even better, recent figures signal that the recovery is actually getting stronger lately. The real estate cycle is long term by nature, and the sector is recovering from really depressed levels, so there is still plenty of upside potential in the current cycle. Below are five ways to benefit from an improving real estate market.

The Data

The following chart from the Federal Reserve Bank of St Louis shows a clear and important conclusion: housing starts are recovering from the collapse they had after the implosion of the credit bubble. The fall was much deeper than in other occasions, and the recovery was preceded by an unusually long stagnation, but the trend is now up and it has a lot of room to run.

Recent data is quite optimistic: according to the Commerce Department housing starts increased 15% last month to a seasonally adjusted annual rate of 872,000, the highest level since July 2008. Compared with a year earlier, new construction was up by nearly 35%. This was better than the adjusted annual rate of 768,000 expected by economist for the month of September, and Starts in August were revised up to a rate of 758,000, reflecting a 4.1% increase from July.

Two Diversified Bets

Selecting individual builders is no easy task, construction is a low margin business, and many of these companies are still trying to streamline their balance sheets and reduce debt after the crisis. Sector ETFs may provide a convenient alternative to invest in a real estate recovery with controlled risk via a diversified portfolio.

More construction activity bodes well for the SPDR S&P Homebuilders (NYSEMKT: XHB) ETF, which holds a basket of 35 companies with direct exposure to building and real estate.  Homebuilders are almost 30% of assets, but it also includes corporations involved in building products, home furnishings, home-improvement retail, home-furnishing retail, and household-appliance makers.  Builders like Lennar and Toll Brothers are included in the portfolio, but so are other companies like Home Depot and Pier 1 Imports, so this instrument provides wide exposure to a recovering real estate market.

Another sector ETF to capitalize on a real estate recovery is iShares Dow Jones US Home Construction (NYSEMKT: ITB), which owns many of the same homebuilders as XHB, but doesn't have so much exposure to companies in furnishings or other businesses related to real estate. Homebuilders make up almost 70% of the portfolio of this ETF, so this instrument is much more leveraged to construction. For a very direct bet on new building, ITB would be the right choice, while its competitor XHB provides a more diversified approach to real estate in general.

Three Undervalued Stocks

Caterpillar (NYSE: CAT) has done really well since the last recession, earnings per share are at all-time highs in spite of the fact that construction hasn't been very buoyant over the last years. However, due to concerns about slowing demand from the commodity mining business, shares of Caterpillar are trading at a very reasonable valuation: the Price to Earnings ratio near 9.7 is quite low from a historical point of view.

The company owns a dominant market share in the US construction equipment industry, so better times ahead for construction should mean bigger sales for Caterpillar. A depressed valuation combined with the possibility of accelerating earnings growth make this blue chip an interesting way to play the real estate recovery.

When real estate collapsed in 2009, so did the financial system, since credit quality is much related to housing activity. Among big US banks, Bank of America (NYSE: BAC) and Citigroup (NYSE: C) where the ones who got hit the worse, and they wouldn’t have survived without government help. In fact, they are still trying to get rid of the toxic mortgage assets which are holding back their profitability levels.

If real estate continues on a good track, these two banking giants will benefit in a big way, as better market conditions will make it easier for them to clean their balance sheets by selling mortgage assets at better prices. Trading at price to book value ratios of 0.5 and 0.6 respectively, both Bank of America and Citigroup are available for historically low valuations at current levels.

 Bottom Line

The worse is clearly over for real estate, and the sector has a lot of room to run over the following years. Just like the bubble and subsequent collapse were historical events, the current recovery could be a once in a life time investment opportunity.

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acardenal owns shares of Caterpillar and SPDR S&P Homebuilders. The Motley Fool owns shares of Bank of America and Citigroup Inc. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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